3 Reasons why Los Angeles was right to fire S&P

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Apparently, it isn't so fun to get downgraded. Earlier this month, Standard and Poor's downgraded the U.S., which caused a domino effect and pushed down the ratings of bonds issued by other entities implicitly guaranteed by the U.S like some municipalities. The retaliation appears to have begun.

This week, we're learning that some of those local governments are dropping the agency from the group it pays to rate its debt. Meanwhile, the U.S. Justice Department is reportedly investigating S&P for its mortgage bond rating mistakes. Yet S&P rejected a proposal that would have changed the ratings market framework in a way that might have prevented bond issuer retaliation. The agency may only have itself to blame for its situation.

Among those local governments is Los Angeles, which will no longer be paying S&P to rate its investment fund and it’s major exposure to U.S. Treasuries, now that S&P has rated the fund AAf rather than AAAf.

This is occurring in the context of “super downgrades” of municipal bond ratings by all the major agencies: S&P, Moody’s, and Fitch. So, have the ratings agencies proven themselves to be capricious, reactive, and...well, incompetent, given their track record to putting lipstick on subprime mortgage securities before the financial crisis? Or are the doing the good work of good men?

Some of these questions will remain unanswered. But LA was right to can S&P. Why?

It’s all about yield. Take a look at the yield on the 10-year T-note: it’s currently at a 50-year low of 2.08 -- down 50 basis points since the August 5 S&P downgrade. The U.S.A. should get downgraded more often! What that yield says is that prospects for the future of the U.S. economy aren’t very good -- if they were, money would be chasing riskier returns in the stock market and elsewhere. But a flight to quality has shown that U.S. debt is still the safest haven there is. Local investment funds would be...how can I put this? Idiotic? to reduce their demand for that debt. As the very entertaining James Altucher argues at MarketWatch:“Debt ratings” of the most highly liquid bonds on the planet should be determined by one thing only: Yield (in the absence of other information about our ability to default). That makes U.S. bonds the safest AAAAA+ bonds in the world.

S&P was providing window-dressing. The only reasons LA was paying S&P to rate its fund was because it wanted to be able to reassure anyone exposed to the fund that its investments were ironclad. If you were concerned on that point, you could simply look at how much of the $7 billion -- $5.6 billion -- was tied in Treasuries. Boom! Rock-bottom risk there. Or...you could have considered how much L.A. was paying S&P to perform this completely perfunctory rating: a very perfunctory $16,000.

Investments aren’t debt. Los Angeles is retaining S&P -- as well as Moody’s and Fitch -- to rate its bonds. S&P should be thankful that municipalities even consider this worthwhile and just don’t mount a campaign to get bond investors to concentrate on a yield range as a true measure of whether city is a good bet (see above). But there’s still a distinction to be made. LA gets to decide how much risk it wants to take on with its own investments. But the market makes a call regarding the debt that the city issues. S&P and the other agencies, it could be argued, perform some kind of service to municipal-bond investors by giving them a mechanism by which to quantify risk that isn’t subject to daily fluctuations. That’s in LA’s interest.